Here is recent financial data on Pisa Construction, Inc.
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Stock price $40 Market value of firm $400,000
Number of shares 10,000 Earnings per share $4
Book net worth $500,000 Return on investment 8%
Pisa has not performed spectacularly to date. However, it wishes to issue new shares to obtain $80,000 to finance expansion into a promising market. Pisa’s financial advisers think a stock issue is a poor choice because, among other reasons, “sale of stock at a price below book value per share can only depress the stock price and decrease shareholders’ wealth.” To prove the point they construct the following example: “Suppose 2,000 new shares are issued at $40 and the proceeds are invested. (Neglect issue costs.) Suppose return on investment doesn’t change. Then
Book net worth = $580,000
Total earnings = .08(580,000) = $46,400
Earnings per share = 46,400/12,000 = $3.87
Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.70.”
Evaluate this argument with particular attention to the assumptions implicit in the numerical example.
Investment in cash: $40*(2,000) = $80,000 => the total market value of the company will increase from $400,000 to $480,000. Hence a per-share market value of $480,000/ (10 000 + 2 000) = $40 Using the proceeds for making a bad investment can decrease the market price. Calculate the value of Tobin's q for existing assets: q = 400,000/500,000 = 0.8
Suppose these investments ($80,000) are alike from the market and investor’s point of view, so the market value will be 0.8*($80,000) =$64,000. A per share price of $464,000 (it is 500 000 *0.8)/ (10 000 + 2 000) = $38.70. So it is not the sale of additional shares of stock that decreases the stock's price. This can be called the investment of money in insufficiently profitable ventures.
This case estimates features of issuing new shares below the book value. It tries to...